423 The future network economy – development of the clearing industry and define their respective market niches. Once they have done so, they can continue to leverage their installed base and specific competitive advantage to provide unique value-added and tailor-made services to their customers. Implementing a customer-focused strategy will require innovation, creativit y and determination. Ultimately, these dynamics might possibly even give rise to newforms of cooperation between CCPs, banks/brokers and other financial service providers, which will lead to further structural changes in the European Value Provision Network. 10.2 European clearing in a global context We emphasise the need to recognise that Europe is part of the global economy. It attracts capital from the rest of the world and European investors also invest outside the EU. EU financial market integr ation efforts should not hinder or obstruct these activities. 28 The rapid growth of cross-border trading, which spans many clearing systems and increases global interdependence, underscores the fact that the clearing industry is ultimately global in coverage. 29 Therefore, any network strategy employed to increase the efficiency of European clearing must also be evalu- ated in a global context. The introduction of clearing links would not only increase the efficiency of the European clearing industry, but the strategy also appears unlikely to hinder or obst ruct global transaction flow and processing for the following reasons: r Clearing networks established through links (provided that these have been implemented properly) have a high growth potential. They make it attractive for other clearing houses to join the network. r Joining this kind of clearing network enables the partnering clearing houses to leverage their installed base, strengthen their unique CCP level network effects, internalise GCM level network effects and continue to offer services tailored to the specific demands of regional market particularities to an increased number of network participants. r Market participants and clearing houses alike would benefit from the com- petitive forces, enhanced flexibility and adaptability, innovation opportu- nities and high growth potential inherent to the link set-up. 28 LIBA (ed.) (2004), p. 1. 29 Also refer to Congress of the United States (ed.) (1990), p. 56. 424 Clearing Services for Global Markets The identified prerequisites for the successful implementation of clearing links also apply to any clearing house outside of Europe wishing to join the network. As in the case of Europe, clearing links’ full potential for efficiency gains can only be exhausted if the partnering clearing houses adequately attempt to overcome the link-inherent starting problem and if clearing members are not forced to participate in the link. Global clearing links could serve to generate a broad scale of additional opportunities for the involved CCP and their clearing members. Certainly, the considerations outlined in section 10.1.5 regarding who should link to whom also apply on a global scale. It is vital to the success of any clearing link that its implementation be both economical for the par tnering clearing houses and serve customer demand. Prior to the implementation of any particular clearing link, it is thus crucial for clearing house managers to gain an understanding of the true wants and needs of all their current and potential clearing members. To summarise, integrating the European clearing indust ry through a clear- ing link set-up appears to be suited to support global growth strategies. 10.3 Summary This chapter ser ved to identify the most preferable future clearing industry structure and delivered recommendations on the industry’s future develop- ment. Additionally, the research results were applied to European exchange- traded cash equities clearing as well as to Europe with regard to its global positioning. The conclusions derived in this chapter are summarised in the following. 10.3.1 Future development of the European clearing industry r Particular attention must be given to the impact of harmonisation and integration initiatives on smaller regional or niche markets and on clearing members with less negotiating and lobbying power than Europe’s high vol- ume clearers. Network strategies that favour some but penalise others are thus not regarded as viable solutions to further European market integra- tion. r Given these criteria, clearing links emerged as the sole network strategy that generates efficiency gains for all clearing members. Links are suited 425 The future network economy – development of the clearing industry to integrate the European derivatives and cash equities clearing industry, respectively. r Although clearing links are the network strategy best suited to increase the efficiency of European clearing, the mere implementation of ‘random’ links between European CCPs will not automatically increase the efficiency of the clearing industry. Links require careful preparation and are not ‘quick fixes’. r Should the partnering clearing houses fail to overcome the link-inherent starting problem, a significant amount of potential for efficiency gains will go unrealised. In this instance, a link initiative would have a negligible impact on the efficiency of the European clearing industry. r Unless the partnering clearing houses have – or are given – the leeway in terms of their ownership and governance structure to fulfil the necessary conditions, however, the strategy of increasing the efficiency of European clearing through links will fail. r A number of arguments suggest that if European clearing houses were to operate as fully fledged corporations rather than profit-seeking CCPs beholden to their members, they could be expected to have greater motiva- tion and incentives to implement measures to overcome the link-inherent starting problem. r Consequently, whereas Europe’s vertically integrated clearing houses have traditionally lacked a clear stand-alone value proposition and their managers will face hurdles in implementing such a strategy, these firms nonetheless have the greatest incentive to implement structures that will ultimately serve to increase the efficiency for all European clear ing members. The same is not true for CCPs operating under the ownership or control of a subset of their clearing members. r This study’s conclusions support the European Commission’s decision to call upon the industry to establish a Code of Conduct (the Code) and are in line with the measures detailed in the Code for cash e quities clearing. r It is vital to the success of a European clearing link initiative that its imple- mentation be both economical for the part nering clearing houses and serve customer demand. The European Commission should thus refrain from forcing any particular link on to the market. r Although the results of this study revealed that to exhaust clearing links’ full potential for efficiency gains, the partnering clearing houses must strive to replicate the size of a Single CCP network, it does not necessarily mean that all European CCPs must be interlinked right from the start. 426 Clearing Services for Global Markets r It is neither necessary nor economical to establish clearing links between virtually all European CCPs from the ver y start in order to increase success- fully the efficiency of European clearing. Rather, clearing members must trust that the scope of the clearing link set-up will gradually be extended over time to cover all major European markets. r A basic framework was provided that can serve as a starting point for European CCP managers to determine which European clearing houses actually ought to be linked and to thus derive their European clearing link strategy: (i) To assess the economic value of any particular clearing link and its respective potential to increase efficiency, CCPs must understand how their various customers value particular links. This will require Euro- pean CCPs to analyse their customers’ usage patterns in detail. The clearing link strategy for Europe should be for mulated on the basis of these findings. (ii) According to Coyne/Dye (1998), three distinct usage patterns can generally emerge: zero concentration, zone concentration and lane concentration. Each of these three patterns requires a different strategy. (iii) For CCPs, the key to formulating a successful European clearing link strategy is in knowing and understanding the needs and wants of their current and potential clearing members. A European clearing link strategy must build on this knowledge to serve to overcome the link-inherent starting problem and effectively increase the efficiency of European clearing. r Clearing links could spur structural changes in the European VPN by increasing the economic attra ctiveness for counterparties to self-clear (many) markets instead of employing intermediary services. This could cause the majority of the European market share to shift from hig h volume clearers to medium and low volume clearers. The currently strong position of high volume clearers within the European VPN could thus be diluted if a clearing link set-up were to be implemented. However, high volume clearers would still benefit from substantial cost reductions. r Structural changes in the European VPN could also result from the compet- itive dynamics between European CCPs and high volume GCMs. European CCPs and high volume GCMs will face great challenges and opportunities in the e vent that such a European clearing link scenario is implemented. Most importantly, clearing houses and GCMs alike will be required to refo- cus and rethink their strategies. Both groups will need to acquire a better 427 The future network economy – development of the clearing industry and more detailed understanding of their customers in order ultimately to develop and define their respective market niche. 10.3.2 European clearing in a global context r The introduction of clearing links would not only increase the efficiency of the European clearing industry, but the strategy also appears to be suited to support global transaction flow and processing as well as global growth strategies. In a final step, Chapter 11 recapitulates the most important findings of this study, provides a c ritical discussion of the research results and concludes with suggestions for further areas of research. 11 Summary, discussion and recommendations for future research This study examined both the efficiency and structure of the clearing industry. Clear-cut definitions together with a concise characterisation and descriptive analysis of the current state of the clearing industry set the stage for the fol- lowing analytical objectives. Besides defining the efficiency of clearing and identifying ways to measure it, this study aimed to determine the efficiency impact of various integration and harmonisation initiatives within the clear- ing industry. The ultimate research objective was to identify the network strategy best suited to increase the efficiency of clearing, benefiting all clearing members. Based on these findings, the most preferable future clearing indus- try structure was identified and recommendations on the industry’s future development were delivered. Although the focal point of the research was the European exchange-traded derivatives clearing industry, the results of the analysis were eventually applied to European exchange-traded cash equities clearing and to European clearing in a global context. This final chapter summarises the study’s most important findings (section 11.1). A critical discussion of the research results leads to recommendations for future research (sec tion 11.2). 11.1 Summary of research results This section summarises the study’s most important findings, chapter by chapter . 11.1.1 Chapter 2 – Setting the stage – definitions and industry setting Depending on the type of service provider, the process of clearing encom- passes a number of services. Most clearing houses today act as a so-called central counterparty (CCP). Central counterparty clearing has become an integral part of clearing services and can even be said to constitute the core 429 Summary, discussion and recommendations for future research of modern financial market infrastructure. These clearing services not only benefit individual market participants, but markets as a whole, by increasing the efficiency of capital markets. While market participants benefit signifi- cantly from the CCP services and additional value-added clearing services provided by these clearing houses, there is another important category to consider: complementary clearing services. These services are not required to maintain the life cycle of a trade, but market participants benefit enormously from them. Nonetheless, today’s CCPs rarely provide a full range of comple- mentary clearing services. These clearing services are u sually delivered by the banks/brokers acting as clearing members of various CCPs. A start ing pointfor the study was provided by identifying and characterising the tiered structure in w hich the provision of clearing services usually takes place: the so-called Value Provision Network (VPN). The VPN consists of two levels of access to the clear ing house, direct and indirect. This study concerned the first level of direct access, and to this end, six different clearing member types were differentiated according to their focus of activity and average European cleared market share: regionally active (low volume) clearers with a prop. or an agency focus, regionally-to-globally active (medium volume) clearers with a prop. or an agency focus, and globally active (high volume) clearers with a prop. or an agency focus. The study also had to consider the particularities of the current structure of the European VPN. First, while there are a number of CCPs, two of them dominate the European market: Eurex Clearing and LCH.Clearnet. Second, a relatively small number of European high volume clearers account for the bulk of the total annual European cleared market share (i.e. approximately seventeen clearing members account for over 70 per cent of the market share). 11.1.2 Chapter 3 – Defining the core issues – efficiency and network strategies The two core research issues were industry efficiency and industry structure. The central criterion for determining the efficiency of clearing was oper ational efficiency, which is influenced by transaction costs. To increase the (opera- tional) efficiency of clearing, it is necessary to minimise clearing members’ transaction costs. The efficiency of the clearing industry is thus increased when the transaction costs that clearing members have to bear are reduced (and vice versa). The total transaction costs of clearing are composed of direct and indi- rect costs, and can be impacted by integration and harmonisation initiatives between clearing houses, referred to as network strategies. For the purpose of 430 Clearing services for global markets this study, four different types of network strategy were distinguished: cross- margining agreements, clearing links, mergers and acquisitions (M&A), and the creation of a Single CCP (within a defined asset class and economic area). 11.1.3 Chapter 4 – Collecting empirical insights – introduction to the empirical study Due to a lack of existing research on the issues of efficiency of clearing and industry st ructure, which could have served as a basis for this study, the author conducted a comprehensive original empirical study. This empirical study consisted of seventy-nine one-to-one interviews w ith different stakeholders in clearing and the distribution of a questionnaire. Although the attempts to collect quantitative data ultimately proved unsuccessful, the interviews provided extensive qualitative data that was used as the basis for the analyses of Chapters 5 and 8. 11.1.4 Chapter 5 – Analysing costs of derivatives clearing – transaction cost studies To determine the efficiency impact of the different network strategies within the clearing industry, it was first necessary to research the transaction costs of European derivatives clearing. With regard to the relevance of clearing costs to different clearing member types, the analysis revealed the following. For low and medium volume clearers with a prop. or an agency focus, as well as for high volume clearers with an agency focus, indirect costs are the core cost drivers. For high volume clearers with a prop. focus, however, direct costs constitute the core cost drivers. The cost analysis also brought to light reasons for the structural partic- ularities of the European VPN and for the competitive advantage that high volume clearers have over medium and low volume clearers. First, the analysis revealed the existence of economies of scale that allow high volume clearers to leverage their fixed cost base. Due to their scale of business, high vol- ume clearers further benefit from a strong negotiating position. Additionally, clearing houses tend to grant high volume clearers preferential treatment in the form of discounts. These factors explain the dominant position of high volume clearers in the European VPN, i.e. why a very high percentage of the average annual European cleared market share in derivatives is concentrated on a few high volume clearers. These clearers’ cost structures allow them to offer intermediary services, and for low and medium volume clearers, it makes economic sense to utilise these services. 431 Summary, discussion and recommendations for future research According to the analyses, network strategies that encourage low and medium volume clearers to self-clear their own markets instead of employ- ing intermediary services could have a significant impact on the structure of the European VPN. Self-clearing enables these market participants to reduce intermediary costs and leverage their internal infrastructure. The research also revealed that NCMs are becoming increasingly aware of clearing costs; many of them view obtaining clearing membership as a viable cost-cutting strategy. The cost analysis also provided the critical step of generating a quantitative estimate of the total European costs of derivatives clear ing borne by clearing members, which amounted to roughly €2.173 billion i n 2005. At €725 million, direct costs represented 33 per cent of total industry costs, whereas indirect costs of roughly €1.448 billion accounted for 67 per cent of total costs. 1 A benchmarking of the European costs of derivatives clearing to other market infrastru cture costs suggested that European derivatives clearing constitutes the most efficient part of the European financial mar ket infrastructure. 11.1.5 Chapter 6 – Exploring theoretical basics – scale effects in clearing Network strategies can give rise to demand- and supply-side scale effects, which can in turn influence the costs of clearing. To establish a basis for analysing the efficiency impact of different network strategies, both demand- and supply-side scale effects in clearing were first classified and explored. The network structure of the VPN was found to consist of two layers (product layer and system layer) and two levels (CCP level and GCM level) and to exhibit a number of positive and negative network effects. Although many of the network effects on the CCP and GCM level are similar, the CCP level gives rise to unique positive network effects that are difficult for GCMs to replicate. Furthermore, by engaging in network strategies and enlarging their range of complementary clearing services, CCPs can internalise network effects that occur on the GCM level. Internalising the strong and important GCM level network effects by the CCP level network is beneficial due to the associated potential for reducing clearing-related transaction costs, thus increasing the industry’s efficiency. Evidence further suggested that economies of scale and scope are likely to exist in clearing, but whether or not increases in either one translate into positive economies for CCPs is highly dependent on the type of network 1 Due to the shortcomings and limitations inherent to the calculation of the estimate, however, it can be assumed that the true indirect cost figure is higher than suggested. 432 Clearing services for global markets strategy pursued and the characteristics and cost structure of the partner ing clearing houses. 11.1.6 Chapter 7 – What theory reveals – framework for efficiency analysis of network strategies The ultimate research objective of this study was to determine the efficiency impact of various network strategies within the European clear ing industry. To this end, an original framework was established that built on the insight of the previous chapters. The analysis based on this framework provided the fol- lowing preliminary conclusions. Besides cross-margining agreements, which generally have little or no potential to increase efficiency, clearing links are the only network strategy that results in efficiency gains for all clearing member types. Whereas the efficiency impact of cross-margining agreements is neu- tral or minimal for all clearing members, regionally active clearers potentially suffer from efficiency losses as a result of M&A and Single CCP initiatives. The analysis further showed that although some network strategies are cost efficient, they are not necessarily profit-maximising for all clearing mem- ber types. Single CCP and clear ing link initiatives, for example, can exert a negative impact on the business model of globally active clearers with an agency focus. The only way for these clearers to circumvent this negative impact is to succeed in restricting access to the CCP level network. How- ever, restricting access to the CCP level network has a detrimental impact on other clearing member types. It would serve to reinforce the current struc- tural particularities of the European VPN, by strengthening the competitive advantage high volume clearers have over l ower volume clearers; globally active clearers would thus continue to dominate w ithin the European clearing industry. Clearing houses could profit immensely from the implementation of a clearing link initiative. A link set-up would enable them to internalise GCM level network effects, strengthen their unique CCP level network effects, lever- age their installed base and continue to offer services tailored to the specific demands of regional markets and different regulatory environments to an increased number of network participants. Nonetheless, the benefits of a European clearing link set-up can only be achieved if the clearing houses endeavour to overcome the link-inherent start- ing problem. Links offer various opportunities for different clearing member types. The starting problem becomes relevant for these clearers in different ways, but it essentially concerns the question of whether the utility derived [...]... about the benefits of such a link set-up The failure of relevant clearing houses and clearing members to recognise the potential value proposition of a clearing link set-up, low internal prioritisation of implementing the link, mandatory open interest transfers, regulatory and political issues can create further uncertainty about the future 434 Clearing services for global markets development of a clearing. .. Name of organisation at time of interview Appendix 4 Questionnaire Questionnaire clearing services for global markets Research objective The focus of this study lies on the identification of the most cost-efficient organisation of clearing service provision in the light of globalised capital markets, and the question of which structures best match the demands of global markets Structure of questionnaire... integration of European clearing processes and alignment of legal and regulatory environments will have an impact on the potential to realise economies of scale and scope through network initiatives Future research is required to evaluate this impact If at any point in the future, European rules and regulations are harmonised, and processes are standardised, a reviewed analysis of the dynamics of the clearing. .. processes • Adaptation of risk management structures and architecture Risk Management Costs • Management of adaptations, e.g connection to a new platform, new release management, testing, etc • Continuous management of IT • Continuous management of IT • Continuous management of IT • Integration of software and hardware • Integration of new interface IT Costs INDIRECT COSTS • Costs related to adaptations affecting... intra-day margin calls • Collateral/cash deposited at clearing house for variation margin • Amount of liquidity at customer tied to ensure funding of intra-day margin calls • Collateral/cash deposited at clearing house for initial margin • Funding effort for regulatory capital requirements • Contribution to default fund Cost of Capital • Initial one-off payments Service Provider Charges • Fixed annual/monthly... European clearing A basic framework was provided that could serve as a preliminary guide for European CCP managers to identify the most appropriate clearing link strategy Additional research is nonetheless required to determine which European CCPs should ultimately establish clearing links Additional econometric analyses measuring the efficiency of clearing and the efficiency impact of network strategies... is the question of innovation in clearing: what is the future role of clearing houses? Will initiatives emerge that successfully compete with CCPs, particularly in the OTC market? Who are the potential competitors of clearing houses? What impact will this have on the structure of the VPN and the efficiency of clearing? Appendices Appendix 1: Matrix overview of clearing- related transaction costs (part... reductions on the clearing member level are truly passed on to NCMs and other customers The extensive qualitative data obtained from the interviews served as vital input and formed the basis for the cost analyses and case studies Nonetheless, more research based on quantitative data is needed on the different cost categories and total costs of clearing This should particularly strive to address the shortcomings... in the context of European clearing links will regard more details of the future structure of the European VPN More network economic research is also needed with regard to standard setting in the clearing industry The analysis suggested an inverse relationship between average costs and the number of contracts cleared, but empirical research is needed to examine 438 Clearing services for global markets. .. research addressing these details is therefore required The case study analysis suggested that mandatory open interest transfers can potentially aggravate the link-inherent starting problem More research is needed on the issue of who actually owns the open interest that CCPs hold on behalf of their clearing members Such research should also provide a more detailed analysis of the economic impact of mandatory . this impact. r If at any point in the future, European rules and regulations are harmonised, and processes are standardised, a reviewed analysis of the dynamics of the clearing industry should take place to. collect quantitative data ultimately proved unsuccessful, the interviews provided extensive qualitative data that was used as the basis for the analyses of Chapters 5 and 8. 11.1.4 Chapter 5 – Analysing. tisation of implementing the link, mandatory open interest transfers, regulatory and political issues can create fur ther uncertainty about the future 434 Clearing services for global markets development